JANET McFARLAND and ELIZABETH CHURCH find companies are planning for the worst as the costs of being wrong skyrocket

Canadian National Railway Co. chairman David McLean thought he was heading into a routine meeting one morning in December, 2002, to talk about renewing chief executive officer Paul Tellier's employment contract.

Instead, he faced one of those moments a chairman dreads.

Mr. Tellier -- who had been named Canada's CEO of the year in 1998 for his success in transforming CN from a moribund Crown corporation into North America's most efficient railway -- revealed he was leaving to head up troubled manufacturer Bombardier Inc.

Suddenly, CN's board not only had to act quickly to minimize the stock market impact from the news that its star CEO was leaving, but it had to find someone to fill Mr. Tellier's large shoes. "If we had dilly-dallied, we would have been just killed," Mr. McLean says.

It was the kind of crisis that tested a board's mettle, and highlighted the value of advance planning for different bad-news scenarios. At many of Canada's largest companies, crisis management has become a board priority in the current climate of unforgiving markets and demanding shareholder activism.

The costs of mishandling bad news have never been so high. Corporate errors now commonly generate not only demands for reform from investors, but also a flurry of class-action lawsuits against directors, and a sharp selloff in a company's shares.

"The consequences are more in the public domain," says corporate director David Beatty, who is also managing director of the Canadian Coalition for Good Governance. "And they are more serious in terms of the financial consequences to the corporation, and potentially to the directors in terms of loss of reputation."

As a result, senior directors say boards are spending more time preparing for crises, especially trying to anticipate problems before they emerge.

"More and more boards are being pro-active, not just when the crisis arises but in trying to avoid getting to that point," says David O'Brien, chairman of both Royal Bank of Canada and EnCana Corp.

Mr. McLean at CN had taken a board governance course at Harvard University in 1998, and says one of the lessons taught was that a board is like a fire department: "You have to be ready in a crisis."

CN was able to move quickly only because of the advance planning the board had done on succession strategies and even on worst-case scenarios, such as the unexpected resignation of the CEO. The board even has a backup plan in the unlikely event of the CEO's unexpected death.

The board's human resources committee met the same morning it learned of Mr. Tellier's departure to discuss appointing a successor. And the full board met the next day, agreeing to offer the top job to CN's chief operating officer, Hunter Harrison.

"The company hasn't missed a beat with our new CEO, so I think we made the right decision," Mr. McLean says. "It was a test of the board. The hose was working and the fire was out."

As crises go, CN's board could have seen far worse. In Canada this year alone, Stelco Inc. was granted court protection from creditors while Air Canada emerged from its own bankruptcy protection. CP Ships Ltd. saw its shares pummelled after revealing an accounting restatement, and Nortel Networks Corp. announced it was firing its CEO and other executives following a review of its major accounting problems. Meanwhile, Hollinger Inc. faced shareholder demands for an independent investigation, while MI Developments Inc. was forced by shareholders to back off a controversial plan to buy all the shares of Magna Entertainment Corp., and Molson Inc. saw its shareholders protest a plan to merge with Adolph Coors Co.

Some boards have faced the ultimate test. At companies like Dimethaid Research Inc. and Creo Inc., shareholders launched all-out proxy battles this year to replace the entire board of directors.

These sorts of crises are not new, but many directors are unused to finding themselves in the spotlight as investors increasingly shift the blame beyond management to also question a board's actions and decisions.

Corporate lawyer Peter Dey, who sits on the boards of CP Ships, Stelco and Atlas Cold Storage Income Trust, which have all faced crises in the past year, says the markets have become far tougher on boards. CP Ships, for example, has faced a flurry of lawsuits since revealing in August that it had to restate its profit for nine quarters back to 2002, as a result of "accounting deficiencies" uncovered by a new software system.

He joined the Atlas board last year after initially being hired as an adviser. But he was already on the Stelco and CP Ships boards when their recent problems occurred.

"I've seen it from the perspective of an adviser, and I've seen it from the perspective of a corporate director. It's a lot easier to be the adviser," Mr. Dey says.

Given his experience, it is perhaps unsurprising that Mr. Dey says one issue a board has to confront quickly in a crisis is whether it can solve the problem alone, or needs to bring in outside expertise. That can mean adding new directors to create a special committee, or hiring special advisers to the board.

"There's always a tension to decide if the problem can be fixed internally or not," Mr. Dey says.

He says there is a natural instinct to want to contain a problem, sometimes making it difficult for boards to opt for a strong response in the hope that a smaller adjustment will be good enough. This may not be the right solution, he says.

"That's why fresh eyes make a lot of sense," he says.

At Atlas Cold Storage, for example, the board hired a new director to join a two-person committee to examine its accounting problems, and the committee hired Mr. Dey as its legal adviser. The committee's report led to a substantial replacement of directors on the board.

Mr. Dey says the special committee process makes it easier for directors to accept difficult decisions -- even to agree to replace themselves -- because events take on momentum.

"For the board to depart from a committee's recommendation, it would have to have very supportable grounds for doing so," he says. "You've started the process, and you have to dance with the one you brung."

Mr. Dey also recommends that a company's major shareholders become more engaged during a crisis. Shareholders can guide a board on hard decisions, he says, including the need for new directors or new management.

"If I had to characterize their role, it's to force upon the board a reality check," Mr. Dey says. "And if the reality check says. 'Hey, you need some new eyes for a fresh look at what has transpired here,' then the shareholder can force that. That's a very constructive dynamic."

Claude Lamoureux, chief executive officer of the Ontario Teachers Pension Plan Board, agrees that major shareholders like Teachers can offer another perspective during a crisis -- preferably one that will be thoughtful and take a longer-term perspective.

"Most directors see a crisis maybe only once in their lifetime, whereas a large owner . . . we see a lot of these things over and over," Mr. Lamoureux says.

"And eventually you can offer some advice. But it's not every board that wants to take advice. Some people, it's like, 'don't bother us, we know what's good for you.' "

He says shareholders are more aligned with proposals of any sort when they have been consulted, even if all of their advice was not accepted.

"You tend to vote for them at that point. You feel more part of the process," he says.

Mr. O'Brien says one of the toughest decisions for any board confronting a problem is determining when a solution or strategy should be scrapped.

"It is a continuum of things, but ultimately a board says, 'We have had enough now, and we are going to move on to something else,' " he says.

At Air Canada, where Mr. O'Brien was a director until he resigned last November, the board had to confront a series of setbacks between 2001 and 2003, including a steep drop in air travel after Sept. 11, 2001, followed by another setback when the SARS virus hit Canada.

"I would say the board came to the conclusion before management did that we had to go into [bankruptcy protection] and try to restructure this whole thing," Mr. O'Brien says.

Although external events had battered the company, he says Air Canada's management and board concluded that the company's structure was also uncompetitive because of its high overhead costs, including higher labour costs than non-unionized competitors.

"It was just a business model that wasn't going to work any more. The board was caught in the middle between management, the unions and the government," he says.

Mr. McLean from CN says there are obvious situations where boards must really "get involved in a major way," such as when there is evidence of misconduct. But he says another such case happens when companies decide on major acquisitions.

During one huge acquisition for CN, he says the board was called together to meet just days before Christmas, with all directors in attendance, as well as a full assortment of financial advisers and lawyers.

"I said, 'Leave the experts outside. The board has to talk about this.' We went around the table and talked for two hours and then brought in the experts," he says. In the end, the board decided to proceed, but Mr. McLean says it was a "gut-wrenching" decision.

"That's what I mean when I say they have to be there in a crisis. You don't get a second chance."

While acute crises must clearly be dealt with by a board, Mr. Beatty at the CCGG says boards don't appear to be moving any more quickly to deal with slowly emerging problems, like the need to replace a CEO after a period of underperformance.

He says CEO succession is a board's key responsibility, and needs to be constantly planned and reviewed because changing a CEO is "hugely disruptive and has to be undertaken with extraordinary care."

He says the best boards always have a succession plan ready, including a "bus strikes the CEO" envelope, which contains instructions in the event a catastrophe befalls the company's top executive. And it should be reviewed every six months to make sure it is still appropriate.

Mr. Dey, meanwhile, argues for more tolerance from shareholders when a company hits a crisis.

He says the pendulum has swung so far that directors are held responsible for every misstep, even though not all of a company's problems signal a governance failure by the board.

"There are examples where a failure I think is so remote from the board of directors that it's unfair to hold the board accountable for that failure," he says.

"On the other hand, if something happens right under their nose -- if they waive a conflict-of-interest policy, for example, and the result is that the company incurs huge losses -- then it is directly attributable to the governance system."

Board Games

CANADA'S DEFINITE CORPORATE GOVERNANCE RANKING

TUESDAY

At the top: Manulife

Chairman Arthur Sawchuk says it is time for corporate boards to focus on value creation, rather that protecting the reputations of management and directors.

At the bottom

Some of Canada's biggest companies don't heed investor concerns and regulators' guidelines about buffing up the governance record.

The rankings

Canada's definitive ranking of corporate governance and board composition, and a peek inside the Report on Business marking system.

WEDNESDAY

The new directors on board

It helps if you have a blue-chip background, but the clubby world of directors is getting larger and more diverse.

YESTERDAY

Winds of change

In an era of increased accountability, investors are making public demands for change. And directors undergo performance reviews.

TODAY

Tracking turmoil

Boards have handled a range of crises this year, from bankruptcy protection to allegations of management impropriety.

ON-LINE

More data

A full explanation of the Report on Business's governance standards, plus the results for each company at globeandmail.com/business

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